By Hamlin Lovell, NordicInvestor

This article forms part of our upcoming report on Alternative Fixed Income

Wealth manager Formue manages NOK 128 billion (c. EUR 12.5 billion) and has offices in Norway and Sweden. It allocates to a wide variety of liquid and illiquid alternative and private credit, within diversified and dedicated portfolios. NordicInvestor interviewed the firm’s Head of Hedge Funds and Private Debt, Cian Walsh, to find out how the allocations are responding to the new market climate. All of the interview relates to Formue’s hedge funds and private debt team, not Formue as a whole.

Formue’s diversified funds of hedge funds would view 20% as a neutral allocation to alternative credit. It also runs dedicated private credit vehicles which are mainly in level 3 or “marked to model” assets, but which also have 20-40% in level 2 or “marked to counterparty quote” type assets.

Formue invests in alternative credit to enhance risk adjusted returns. The allocation is intended to provide yield pickup, risk mitigation through structuring and asset backing, as well as diversification and decorrelation benefits versus traditional credit.

Tactical allocation shifts: adding private credit and EM corporates, reducing trade finance

In the less liquid space, private debt is expected to grow from 1% of assets to between 3 and 5%. “This is part of a general asset allocation shift from traditional equities and bonds and into alternative credit, right across the firm, based on more attractive yields,” says Walsh, an Irishman who lives on the West Coast of Norway. Allocations to direct lending, specialty finance, and asset-backed lending, could all increase.

Meanwhile, trade finance and insured trade finance are being reduced. “The risk/reward is poor as the world is deglobalizing, which upsets supply chains in global supply routes, even without the Russia/Ukraine war. We have had no exposure to Russia or Ukraine but have seen some small losses in other regions including Asia and Lain America,” says Walsh.

These concerns are specific to trade finance, and there is no general aversion to emerging markets. “In the liquid space we see parts of emerging market corporate debt as attractive. This is mainly commodity producers as a way to hide from high inflation. We also have exposure to EM sovereign debt in macro funds.” says Walsh.

Target returns around 10%

Formue is aiming for returns of 8-10% in private credit, and sees >10% achievable in parts of public emerging market corporate debt. “On the private credit, yields could contribute most of the target, but fees, penalties and step-ups can also add to returns. In EM debt, return drivers can vary a lot because some paper with relatively low coupons could be trading well below par,” says Walsh.

Private credit yield pickups have not fully tracked the blowout seen in public markets, so yield pickups have in fact compressed. However, on a risk-adjusted basis they remain attractive. “There are opportunities to tighten up covenants, and increase ownership. Private credit is open for business this year, while public credit markets are finding it more difficult get the deals done,” says Walsh.

In private credit, Walsh expects an average yield pickup of 400 basis points, including several risk premiums: illiquidity, complexity, sourcing and structuring. However, he does not find gyrations in the yield pickup a useful indicator for timing allocations. “Private debt credit risk premiums have remained fairly steady and don’t adjust much to public debt spreads. Therefore, a relative comparison is not recommended. It only gives a view on how cheap/expensive public debt is at a specific time.”

The yields on private debt are often referenced to floating rates, where the outlook for interest rates partly depends on the maturity: “we are seeing some yield curve flattening, with upwards pressure at the short end and downwards pressure at the long end,” says Walsh.

He also expects that inflation could remain in mid single digit levels for some time: “if higher inflation filters through to interest rates, this will boost yields on private debt which, is mainly floating rate related”.

Cash is simply held in cash, which has always produced some positive return in the NOK base currency.

Liquidity tolerance and outlook

Diversified fund of fund products will generally have a maximum of 15% in less liquid credit. “This can be defined as either a vehicle with liquidity of at least 1.5 or 2 years, or one investing in level 2/3 assets,” says Walsh. Formue could account for up to 25% of an individual fund.

Formue is keeping abreast of secondary markets, but they do not currently influence the firm’s liquidity appetite. Business Development Companies (BDCs) listed on the US equity market are an example of secondary market liquidity in private credit funds. “We invest in private funds run by managers who also have BDCs, but do not invest in BDCs due to the mark to market volatility of discounts to NAV. We would like to see robust liquidity programs to manage discount to NAV,” says Walsh.

In fact public credit markets are where Walsh is most worried about liquidity risks: “central banks are withdrawing, and volumes have been declining for some time, during a period of price discovery. Within our hedge fund and private credit vehicles, we have no passive exposure to credit and rely on managers to cope with liquidity risk,” he says.

ESG and asset manager carbon footprints

Formue’s hedge fund team makes an almost entirely qualitative assessment of managers’ ESG: “the firm and culture DNA must be ESG/RI focused. The vast majority of our hedge funds meet our culture criteria, and we have never had to redeem for ESG reasons”.

Walsh finds carbon footprints are most useful at the level of the asset management company, rather than their underlying portfolios:”I do not focus on carbon footprints for hedge funds with active trading strategies and shorter holding periods, since they are not buy and hold,” he says.

Alternative credit is not being used for impact investing per se, but some managers are targeting various UN SDGs.

“The EU SFDR is less relevant for hedge funds, as they are typically not domiciled in Europe,” says Walsh.

Fund domiciles: offshore freedom and flexibility preferred

Funds are mainly offshore Cayman vehicles: “we find onshore vehicles can be more expensive and more restricted on leverage and other investment freedoms. We would rather allocate to hedge funds with the freedom to invest to the best of their abilities, and not have their hands tied,” he argues.

Manager selection and due diligence: new managers need to show crisis credentials

Walsh finds managers mainly through his existing network and relationships, but media, investment advisors and third party marketers can also be helpful. He finds conferences and capital introduction teams less useful.

Albourne Partners is used for data and analytics, such as desk-based peer group analysis, but investment and operational due diligence are mainly done in-house.“An exception could be new strategies such as cryptocurrencies or decentralized finance, where it would make sense to get outside due diligence,” Walsh acknowledges.

There are 75-100 manager meetings per year of which 25 might be with new managers. Formue runs a fairly concentrated FoHF portfolio with the top 12 funds making up 80% of the portfolio. “These top holdings are not static, and we expect to turn over 1-2 allocations per annum,” says Walsh.

When assessing new managers, the length of track records per se are less relevant than whether the time period included a crisis. “The 2013-2017 period does not help us test how managers cope in a crisis. We like to see how managers performed in any crisis period of higher volatility, whether it was caused by equity markets, credit markets, oil price or other factors,” Walsh concludes.